- Interest rate risk can arise for investors holding fixed-income instruments or stock market investments that are sensitive to interest rate fluctuations.
- Firms holding debt with a floating interest rate can suffer losses when interest rates rise, leaving investors with significant losses.
- Investment tools such as interest rate derivates and floating rate instruments can rescue investors when an interest rate rise is expected.
Investors often turn to bonds and bond funds to diversify their portfolio or simply hold fixed-income assets. Often perceived as risk-free investments, bonds are susceptible to a set of risks, one of which is interest rate risk.
Simply put, interest rate risk is the exposure of firms to changing interest rates and is a risk that even companies are vulnerable to. It can adversely impact the revenue of the firms, further causing a setback to their stock market performance. Firms holding debt with a floating interest rate (such as LIBOR) can be in a serious turmoil if the rate increases.
Conversely, interest rate reductions can spur activity in sectors such as construction and automobile manufacturing due to increased credit-based demand. However, an increase in the rate can pose a challenge for these sectors, causing a drop in the investors’ portfolio returns.
Thus, interest rate risk can present itself in various forms for investors, making it necessary for them to manage the risk.
Here are a few ways in which interest rate risk can be minimised:
Shifting to shorter-duration investments
Short-term investments are a viable option that investors can explore when they expect interest rates to rise. Selling investments that are long-term and, thus, more open to interest rate risk should be the first order of business for investors. Due to the inverse relationship of bond prices with yield, when interest rates rise, bonds tend to lose their value. Thus, investors can protect themselves from increased losses by selling their long-term investments and instead choosing shorter-term investments.
Switching from long-term investments to those with a shorter maturity can considerably reduce the risk faced by investors as these investments face lesser disturbance due to interest rate volatility.
Hedging through various derivatives
Hedging for an investor involves taking an opposite position in related assets, which in this case are interest rate derivatives, to offset the losses from existing investments. These derivatives include forward rate agreements, swaps, futures, and forwards.
In interest rate swaps, two parties mutually swap the interest rates that are attached to a liability. Typically, parties swap a floating interest rate for a fixed one or the other way around. Both parties enter the agreement with the aim to mutually benefit from the swap. Swaps are like Forward Rate Agreements, in which interest rates are forwarded among parties.
Additionally, interest rate futures allow the involved parties to decide upon the price if an interest paying asset that is to be exchanged between them in the future. This eradicates interest rate-based fluctuations that the price of the asset goes through.
Floating rate investments for when rates rise
A good method to redeem the losses caused by interest rate fluctuations is to invest in floating rate investments when interest rates are rising. Floating rate investments would generally offer higher returns in the specific scenario when rates are rising. Alternatively, if investors expect a drop in rates owing to upcoming policy changes or related factors, then they can sell their floating rate investments to avoid potential losses.
Additionally, investors can explore high yield bonds when rates are rising. These bonds are also referred to as “junk bonds” and are deemed as risky investments because they are generally issued by companies with a lower credit rating. Thus, the higher risk is compensated for by the above-average yield offered on these bonds.
Diversification of portfolio
Diversification allows investors to hedge against interest rate losses by investing in assets or securities that may indirectly benefit from interest rate fluctuations. For instance, a bond holder can obtain higher returns from equities when interest rates are rising by simply investing in those equities that benefit from rising interest rates, such as banking and insurance stocks.
Additionally, diversifying one’s portfolio with commodities when interest rates are on the rise is also a good approach to hedging. These unrelated assets can help the investor gauge higher returns from that part of the market that benefits from changes in the interest rates. Generally, precious metals tend to perform well when interest rates rise. Thus, investors can hold these additional securities in their portfolio to hedge against losses.
All in all, a balanced portfolio along with the financial prowess of the investor can protect him/her even in the face of adversity. Investment tools such as interest rate derivates and floating rate instruments can rescue investors when an interest rate rise is expected. However, investors must carefully investigate these tools and develop sound knowledge about the risks surrounding them before going for a new investment.